Why U.S. Companies Need Tax Havens

Unlike almost all of their foreign competitors, American companies
face a tax penalty when they compete for market share around the world.
But this penalty is not imposed by protectionist foreign governments.
Instead, this discriminatory tax--known as worldwide taxation--is
imposed by American politicians.

Congress and the Obama administration now want to make the penalty
even more severe, even though that will further tilt the playing field
in favor of companies from other countries.

The U.S. is one of the few nations in the world to impose worldwide
taxation. This means that American companies are taxed not only on the
income they earn in the U.S., but also on income they earn in other
countries. That is a problem since any money earned abroad by American
companies already is subject to all applicable taxes in those other
countries. That's not too surprising. After all, the IRS taxes foreign
companies that earn money in America.

President Obama has proposed to make America's tax system even less competitive by restricting deferral.

Yet if two countries tax the same income, that is an unambiguous
form of double-taxation. Even the politicians in Washington realize
that two layers of tax would cripple American companies trying to earn
market share abroad. As such, American companies with foreign income
are allowed a credit for corporate income taxes paid to foreign
governments.

That's certainly better than nothing, but now we come to the second
problem, and it's a biggie. The U.S. has a 35% corporate tax rate, much
higher than most other countries. This high corporate tax rate,
combined with worldwide taxation, is a huge liability for American
companies.

Let's say an American company is competing around the world against
a Dutch company. Both companies have manufacturing divisions in
Ireland, servicing divisions in Hong Kong and financing divisions in
the Cayman Islands. And to keep our example simple, let's assume each
division generates $100 million of profit.

Now let's add taxes to the equation. The Irish government imposes a
12.5% corporate tax on both companies. The Hong Kong government imposes
a 16.5% tax on both companies. And the Cayman government imposes zero
tax on both companies.

But the U.S. has a worldwide tax system, and the Netherlands has a
territorial tax system. This means that the American company owes tax
to the IRS on the $300 million earned in the three jurisdictions, but
the Dutch company does not need to pay any additional tax on its $300
million. And even if the American company is allowed full credit for
taxes paid to the three foreign governments, its total tax bill will be
more than $100 million--more than three times higher than the tax bill
for its Dutch competitor.

In a competitive global economy, this is a huge disadvantage for an
American company. This is why politicians, in an unusual display of
common sense, created a policy known as "deferral," which allows
American companies--in some circumstances--to delay the extra tax. U.S.
businesses still don't get to compete on a level playing field, but
deferral does significantly reduce the self-imposed tax discrimination
caused by America's worldwide tax system.

Ideally, policymakers would try to fix this competitive disadvantage
by lowering the corporate tax rate or shifting to territorial taxation
(the commonsense notion of only taxing income earned inside national
borders). In the strange world of Washington, however, moving in the
right direction does not seem to be an option. President Obama has
proposed to make America's tax system even less competitive by
restricting deferral.

You're probably asking yourself, "Why would Obama want to hamstring
American companies in the global marketplace?" There are two
explanations. First, politicians love tax revenue, and the president's
budget claims that this portion of his tax plan will collect as much as
$210 billion. In reality, it won't collect anywhere near that much
because of Laffer Curve effects, but that's no obstacle to politicians.
They'll assume the money will materialize, and further increase the
burden of government spending.

The second explanation is that some people in Washington think
deferral is a subsidy "to move jobs offshore." They argue that if an
American firm can earn money in Ireland and only pay 12.5% tax, this
gives them an incentive to close down factories in America and ship
them overseas.

Since nearly 90% of what American companies produce overseas is sold
overseas, according to Commerce Department data, there's not much
evidence that this is happening. But there's actually some truth to
this argument. If a company can save money by building widgets in
Ireland and selling them to the U.S. market, then we shouldn't be
surprised that some of them will consider that option.

But this does not mean the president's proposal might save some
American jobs. If deferral is eliminated, that may prevent an American
company from taking advantage of a profitable opportunity to build a
factory in some place like Ireland. But U.S. tax law does not constrain
foreign companies operating in foreign countries. So there would be
nothing to prevent a Dutch company from taking advantage of that
profitable Irish opportunity. And since a foreign-based company can
ship goods into the U.S. market under the same rules as a U.S.
company's foreign subsidiary, worldwide taxation does not insulate
America from overseas competition. It simply means that foreign
companies get the business and earn the profits.

If deferral is curtailed or eliminated, several bad things will
happen. American-based companies will become less competitive since
they will face a higher tax rate. Those U.S. companies also will lose
market share around the world since foreign companies will have an even
bigger tax advantage. America will have fewer exports, since a big
chunk of our exports are the goods that American companies sell to
their foreign subsidiaries. And American workers will have fewer jobs
because of the reduction in exports.

Sadly, politicians either don't understand or don't care. All that matters to them is that they get more money to spend.